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REITs: The great diversifier
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May 10, 1999: 11:11 a.m. ET
Real estate investment trusts help limit the effects of equity market swings
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NEW YORK (CNNfn) - If you believe what you hear on Wall Street these days, the odds of a stock market correction later this spring are getting stronger day by day.
For the individual investor, this poses an interesting dilemma. On the one hand, you want to protect your assets. On the other, you're afraid to overreact, dump your holdings and sacrifice long-term potential for returns.
Experts say there's one way you can do both - pad your portfolio with real estate investment trusts.
"I think REITs are excellent for the average investor," said CIBC Oppenheimer analyst Jordan Heller. "They provide diversification and they provide attractive yields that are not available just everywhere."
The REIT
A REIT is defined as a corporation or business trust that buys, develops, manages and sells real estate assets, using capital from a large group of individual and institutional investors.
They act much like a mutual fund, since investors benefit from a diversified portfolio under professional management.
REITs are also attractive because most do not pay corporate income tax to the Internal Revenue Service, the National Association of Real Estate Investment Trusts reports. Many states exempt them from income taxes, as well, putting the investment tools in a unique position to distribute nearly all of their income to shareholders - without double taxation.
At the same time, REITs cannot pass tax losses on to its investors. And they are more liquid than private real estate investments, since stocks are traded on the major exchanges.
Today, there more than 300 REITs operating nationwide, with assets of more than $200 billion.
NAREIT spokesman Jay Hyde said the investment tools are generally considered to be less risky than stocks. They also generally underperform the broader market indexes.
"Historically, REITs have performed about the way you'd expect, somewhere between bonds and the S&P 500," he said. "They're really comparable to small cap stocks and have proven to be a better investment over time than direct property investment and bonds."
The rise and fall
REIT stocks enjoyed a wild ride in the commercial real estate boom of the 1980s. But the bubble burst shortly thereafter as the economic recession dug in its heels and investors became worried that asset levels had grown disproportionately large.
The investment products fell further out of favor last year, suffering one of their worst loses in history, as deep-pocket investors became devotees of "all things tech." Last year alone, REIT stocks tumbled 18 percent on average from 1997 levels.
"What has happened over the last 18-months is we had a correction that had more to do with the group being overpriced in the [late 1980s]," said Lehman Brothers analyst Steve Hash. "We've also had a stock market that is very narrowly focused on growth stocks and momentum."
The upside
That's all starting to change.
On April 12, billionaire investor Warren Buffet disclosed new investments in several REITs, including Tanger Factory Outlet Centers (SKT) and Town & Country Trust (TCT), sparking a much-needed sector rally.
"That added legitimacy to the group which was definitely trading at a big discount to its value," said Heller, of CIBC. "That, combined with the move toward cyclicals, provided the impetus for the group to move up."
The NAREIT index, which had been down 8 percent for the year, moved into positive territory in April for the first time in months. Returns are now up 4 percent for the year.
The power of diversity
If you're among the faction that believes the volatile tech sector will continue to reign on Wall Street, despite their recent downturn, analysts say you are perhaps the most well-positioned to take advantage of REIT investments.
Consider this: In their latest study on portfolio diversification, Todd Canter and Keith Pauley of LaSalle Investment Management Securities in Baltimore, found that REITs have had the highest negative correlation to technology stocks over the last six years.
Simply put, that means REITs have been the most effective investment tool in helping to reduce the risks of tech-stock volatility.
"With equity valuations at or above historical highs, investors looking for proven approaches to mitigating risk without foregoing return should revisit real estate," Canter and Pauley wrote. "Real estate, more specifically real estate securities, look particularly interesting given their current levels of valuation and their low to negative correlations with the industry sectors which have driven stock indices upwards in recent years."
The study also reported that REITs are attractive from a valuation perspective, as well. Since the collapse of REIT stock prices in 1998, REIT valuation levels have reached a new cyclical low, it said.
"There's been a lot of interest in REITs because of growing concern about valuation levels in some of the other sectors (such as technology) that have been driving this market," Pauley said. "Most investors would agree it is unrealistic to expect tech stocks to continue going up the way they have for the last five years, with average returns of over 40 percent. As we return to more normal return levels, the need for diversification will become even more pronounced."
Today, the Dow Jones industrial average continues to flirt with 11,000, but some analysts say we could be in for a "significant correction" in the coming weeks - a downturn that could cause the blue-chip index to shed 1,000 points or more.
"REITs will clearly play an important role in smoothing out the bumpiness of other sectors and that is important to all investors," Pauley said.
The buy
It should be noted, however, that REITs are no more insulated from stock market pressures than other securities. But because they already suffered a significant slide last year, Phil Storms, a certified financial planner with Denver-based Westmont Cos., said they're not likely to get hit as hard if and when a correction hits.
"If there is a big market correction, you shouldn't see a lot of correction in the REITs because they've already done it," he said. "You might still see a small correction, but certainly they don't have the potential to drop 25 percent to 30 percent (along with the rest of the market)."
Buying in
If you plan to buy REITs, Storms said it's best to think of them as a "bond substitute."
Don not expect the soaring returns you might have enjoyed with tech stocks. But the stability REITs may bring to your portfolio could be worth just as much, he said.
"(REITs) pay very high dividends - in the last few months several have been up as high as 12 percent," Storms said. "The downside is that they are out of favor now and probably are not going to get the growth potential over the long-haul that the S&P 500 or index funds are going to get."
You should also play it safe - after all, no investment is guaranteed.
"We think you should have a diversified portfolio of REITs," Storms said -- either by choosing a mutual fund that invests in REITs by selecting your own broad range of investments.
Some of the largest real estate mutual funds include Cohen & Steers (RIF), CGM Realty Fund, and Longleaf Partners Realty.
If you're looking to hand pick your own investments, Storms noted that health care REITs, or those that invest in nursing homes and hospitals, are particularly strong right now.
Safeguard your holdings
To be sure, there is no guarantee that adding REITs to your portfolio will help cushion the blow if and when a stock market correction hits. But if you are looking for a way to minimize risk, analysts say you should at least consider them as an option.
REIT stocks, they say, remain significantly undervalued and could be the best bet for bargain hunters angling for greater stability.
(Historically, REITs have averaged 14-percent returns and yields right now stand at about 7.3 percent.)
"I think REITs belong in most people's portfolios, particularly for income-oriented investors," Storms said. "Less so, maybe, for someone 25 years old who can really afford (to ride out) the ups and downs of the marketplace." 
--by staff writer Shelly K. Schwartz
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